Valuation of several stocks enters the red zone

A man walks out of the Bombay Stock Exchange (BSE) building in Mumbai (Photo: Reuters)
A third of the Sensex stocks are currently trading more than one standard deviation (SD) above their 10-year average price-to-earnings (P/E) multiple, while six of them are trading at two SD above their 10-year average multiple. This means that 10 out of the 30 index stocks are valued 68 per cent more than their 10-year average P/E multiple.

Any stock or index trading above one SD is considered to be in the red zone, while two SD (this means 95 per cent more than the average) above the long-term average is considered a bubble zone. At the end of December 2007 — just before the big market correction in January 2008 — 11 of the 30 index stocks were trading more than one SD higher than the average.

Some of the top stocks with current valuations at two SD or more than their 10-year average include Reliance Industries, ITC, HDFC Bank, State Bank of India and Maruti Suzuki. Together, these stocks account for 40 per cent weight in the index. Index weight is based on the free-float (non-promoter shares) market capitalisation.

In comparison, at the end of 2007, seven index companies — with a combined weight of 27 per cent — were trading in the bubble zone.

The benchmark index valuation also shows a similar level of exuberance on the part of investors. The index is currently trading at 23.3 times its trailing 12-month underlying earnings — two notches below its P/E multiple of 25.3 times during the last quarter of 2007, which has been the most expensive ever for the benchmark.

The BSE MidCap index is also following in the footsteps of the Sensex. The current trailing P/E of the mid-cap index is 31.6 times, against its all-time high of 32.9 in the last quarter of 2007. All the valuation ratios are quarterly averages to weed out daily and weekly fluctuations.

This is making many analysts uncomfortable about the current market valuation; they expect the market to correct, going forward.

“It seems to us that investors are enamoured of the stock price performance and oblivious to the financial and operating performance. The earnings per share of many of the market-favourite companies have hardly gone up and, in some cases, halved over the past five years. On the other hand, stock prices are generally up significantly; some over 100 per cent during the period. A lot is riding on a big turnaround in the fundamentals of the companies,” wrote Sanjeev Prasad of Kotak Institutional Equities, in his recent report. 

“The valuations of Indian markets have shot up essentially on the basis of domestic and geopolitical stability. However, fundamentals (earnings) of the companies have not kept pace with rising valuation ratios,” said G Chokkalingam, founder and managing director, Equinomics Research & Advisory. Some of the biggest sectors like information technology, pharmaceuticals and fast-moving consumer goods have posted single-digit growth, while public sector banks continue to reel under stress due to a high number of bad loans. “If the earnings recovery doesn’t happen in the next two-three quarters, there could be a crisis in the equity markets,” said Chokkalingam.

The valuation in the broader market is even stiffer. More than 40 per cent (216 companies) of the BSE 500 index stocks are trading at more than one SD above their 10-year average P/E multiple. At the end of December 2007, only 136 companies were in the overheated valuation zone. Further, 103 stocks of the 216 are trading more than three deviations above their 10-year average P/E multiple, indicating an extreme exuberance among equity investors about the growth prospects of second- and third-tier companies.

Analysts fear a market correction could be more painful this time around than in the past, given the record high market capitalisation in the small- and mid-cap universe. The combined market capitalisation of all listed companies is up two-and-a-half times since the previous high market peak of end-2007. In comparison, the benchmark index has gained only around 50 per cent during the period. 

“To reverse a modest five per cent correction in the broader market, bulls will now require nearly $100 billion worth of fresh inflows. This is beyond the means of domestic investors, if foreign investors don’t oblige,” said Chokkalingam.

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